Risky move on bank licences

This newspaper reported last week that the Reserve Bank of India (RBI) is ready to let large companies set up banks. It would be a bad move.

Compared with industrial and service companies, banks are more tightly regulated in most countries because they have high leverage and can be the source of economic instability, as the world was reminded once again during the financial crisis. So central banks and regulators have good reason to pay close attention to who owns and controls a bank.

The main economic risk in allowing large companies to own banks is that the task of creating credit to the economy could become secondary to funding the business of the mother company and its various affiliates. Credit would then be suboptimally allocated. The nationalization of banks in 1969 was in response to this very problem, when industrial houses misused the banks they controlled while the rest of the economy remained credit constrained.

RBI could potentially minimize some of these risks through better oversight. Our own report said that the central bank would allow companies to set up banks only after it gets the right to oversee the operations of the promoting company and the right to supersede bank boards. RBI has a better regulatory record than many of its global peers, but regulating a bank run by an industrial house (especially an Indian one with a complex web of ownership and control) may be a more difficult ball game than keeping an eye on a staid public sector bank.

Meanwhile, the timing of the push to give bank licences to companies is also odd from the perspective of political economy. There are very valid concerns right now about concentrated economic power and regulatory capture, as encapsulated in the debate about crony capitalism. To allow corporate banks against this troubling backdrop makes no sense at all.

There are compromise solutions. Tighter oversight by RBI is surely an option. Another is linking the size of a corporate-owned bank with the amount of control a promoter group can exercise. In other words, the maximum allowed shareholding of the promoter group could be reduced as the capital of the bank increases, to ensure that financial stability is not put at risk. But that would destroy the strongest reason to allow corporate banks—access to large amounts of start-up capital.

India needs more banks to increase competition and foster financial inclusion. Despite the recent debates over microfinance, we believe that the relevant policy right now is to nurture small but well-capitalized new banks, especially helping microfinance firms and non-banking financial companies with deep local knowledge to convert into banks, albeit with very strict capital adequacy requirements.

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